Understand Your Business Financials with Financial Statement Analysis
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If you don't know the financials, you don't know the business. Financial statements are often an overlooked tool to better understand a business. Financial statements are essentially the scorecard of the business. If you can’t read the scorecard your business may be in jeopardy and you not even know it. Many business owners don’t understand the story they tell. This deck helps you understand the basic financial statements, the importance, steps of an analysis, ratios, and a quick valuation.
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Understand Your Business Financials with Financial Statement Analysis
- 1. The Story from your Financial Statements L. Brent McClure, CPA @LBMCPA
- 2. Agenda for Today • Recognize the need to understand financial statements in everyday business • Understand the basic financial statements • Identify appropriate steps to conduct an analysis • Identify the factors that determine how much external financing is needed
- 3. BREAKDOWN: DON’T BELIEVE EVERYTHING THEY SAY, FOCUS ON THE FINANCIAL STATEMENTS.
- 4. • Financial statements are often an overlooked tool to better understand a business • Financial statements are essentially the score card of the business • If you can’t read the score card your business may be in jeopardy and you not even know it • Many business owners don’t understand the story they tell Why should we care
- 6. what is important 1. Balance Sheet 2. Income Statement 3. Statement of Cash Flows
- 7. balance sheet The totals on both sides must equal. The Assets are listed first or on the left, Next the liabilities are listed or they are on the right hand side. Followed by the equity section. Assets = liabilities + equity A snapshot of the business at a point in time
- 8. Income statement Sometimes called a profit & loss statement or P&L. The P&L or income statement tracks the profit or loss of the business Revenues – expenses = profit Measures revenues & expenses over a period of time
- 9. Statement of Cash Flows Measures the amount of cash flowing in and out of the business over period of time Begins with Net Income/Loss Starts with Net income or loss from the income statement and ends with current cash balance. Must equal cash on the balance sheet
- 10. Deeper Dive into the Financial Statements
- 11. Balance sheet Assets are things that you own. Including things that may even have debt attached to it Liabilities are things that you owe Equity is what is left over, beginning with the amount of contributed capital A simple approach
- 15. IncomeStatement
- 16. Income statement Revenues – Costs = Profit/Loss
- 17. Income statement Revenues – Costs = Profit/Loss
- 18. CashFlows
- 19. Stmt of Cash Flows Reconciliation of Cash to Net Income
- 20. Stmt of Cash Flows Reconciliation of Cash to Net Income
- 22. Value of a firm’s equity = 3 2 2 21 R1 FCF R1 FCF R1 FCF … Mathematically this expression can be reduced to Value = GR FCF1 FCF = Funds that can be withdrawn from the business – called free cash flow R = Risk adjusted rate of return G = Expected growth rate Dividend Capitalization Model
- 23. Cause versus Effect Effect ratios measure the results of company actions not their cause. Things like Liquidity, Leverage, & Profitability Causal ratios measure the actions (or lack of actions) that cause the effects.
- 24. Liquidity Measures- Show Ability of Firm to Meet Short-term Obligations as They Come Due • Current ratio • Quick ratio • Defensive interval • Cash conversion cycle • Inventory/working capital • Receivables/working capital • Net sales/working capital • Operating cash flow to current liabilities
- 25. LiquidityRatios Liquidity Category Ratios Quantity of liquidity Current ratio Quick ratio Timing of liquidity Defensive interval Cash conversion cycle Quality of liquidity Inventory/working capital Receivable/working capital Early warning Net sales/net worth Operating cash flow to current liabilities
- 26. Current Ratio • Computed as current assets ÷ current liabilities • Measures the quantity of liquidity • Its size is largely determined by inventory
- 27. Quick Ratio • Quick assets include cash, marketable securities, and receivables • Ratio measures the quantity of liquidity • Differences in quick ratio and current ratio are largely driven by inventory
- 28. Defensive Interval • Numerator is quick assets • Denominator is daily cash operating expenses • Measures the number of days the firm’s liquidity will last if no new sales occur
- 29. Inventory to Working Capital Measures quality of liquidity Company A B Cash $ 2,000 $ 10,000 Accounts receivable 16,000 40,000 Inventory 10,000 60,000 Total 28,000 110,000 Current liabilities 10,000 80,000 Working capital $18,000 $ 30,000 Inventory to working capital 56% 200% Industry average 60% 60%
- 30. Trade Receivables to Working Capital Measures quality of liquidity Company H J Cash $ 1,000 $ 5,000 Trade receivables 6,000 50,000 Inventory 7,000 30,000 Total current assets 14,000 85,000 Total current liabilities 4,000 55,000 Working capital $10,000 $ 30,000 Trade receivables to working capital 60.0% 166.7% Industry average 75.0% 75.0%
- 31. Net Sales to Working Capital Measures the ability of W/C to support sales and in turn support growth Company V W Current assets $ 25,000 $ 25,000 Current liabilities 24,000 11,000 Working capital 1,000 14,000 Sales $150,000 $150,000 Sales to working capital 150 times 10.7 times Industry average 10 times 10.0 times
- 32. • Debt to net worth • Debt to assets • Short-term debt to net worth • Times interest earned • Cash times interest earned • Fixed charge coverage Leverage Measures - Shows Ability of Firm to Meet Obligations as They Come Due
- 33. • Return on Equity = • Net income/Net worth Profitability Measures - Shows Ability of Firm to Earn a Return
- 34. Net Profit to Net Worth Company A B Net sales $2,000,000 $2,000,000 Net profit 20,000 100,000 Net worth 80,000 1,000,000 Net profit to net sales 1% 5% Industry average 3.3% 3.3% Net profit to net worth (ROE) 25% 10% Industry average 8.8% 8.8%
- 35. Illustrative Problem Suppose that a company’s current ratio was 2.5 last year and decreased to 2.0 this year. Last year, its quick ratio was 1.0 and stayed constant. What does this trend suggest? Last Year This Year Current Ratio 2.5 2.0 Quick Ratio 1.0 1.0 The difference between the current and quick ratios is largely inventory. We can see that the ratio of inventory to current liabilities has decreased from 1.5 to 1.0. We can conclude that there has likely been an inventory decrease this year.
- 36. If a company has a debt ratio of 40%; What is its debt to equity ratio? Illustrative Problem
- 37. Solution If a company has a debt to asset ratio of 40 percent, what is its debt to equity ratio? From the balance sheet equation, we know that assets equal liabilities plus stockholder’s equity. So if debt to assets is 40 percent, equity to assets is 60 percent. What this tells us is that the two ratios measure the exact same thing; they just use a different scale of measurement. / 40% 66.7% / 60% debt debt assets equity equity assets
- 38. Effect Ratio Summary Current ratio If small, indicates inadequate liquidity Quick ratio If small, indicates inadequate liquidity Defensive interval If small, implies the company could not survive very long in a financial crisis
- 39. Effect Ratio Summary Inventory to working capital If large, indicates poor quality of liquidity Receivables to working capital If large, indicates poor quality of liquidity Net sales to working capital If large, indicates inadequate liquidity to support sales
- 40. Effect Ratio Summary Debt to net worth If large, indicates increased financial risk Debt to assets If large, indicates increased financial risk Tangible debt ratio Measures debt usage proportionate to tangible assets Short-term debt to net worth If large, implies extremely high risk situation
- 41. Times interest earned If small, indicates insufficient financial solvency—high financial Fixed charge coverage Measures how many times earnings cover all financial obligations Return on equity Key profitability ratio is a measure of the return on owner’s investment in the firm Effect Ratio Summary
- 42. Earnings Quality strong Earnings quality is strong if we perceive that the company can continue to earn at the same rate. Earnings quality is strong if earnings and cash flow follow similar patterns. weak Earnings quality is weak if we perceive that the company is unlikely to continue earning at its same rate and/or earnings and cash flow does not follow the same pattern.
- 43. Earnings Quality- Perceived Ability to Continue in Business • Strength of the balance sheet • Presence of one-time transactions • Age of the assets • Adequacy of R&D • Age and incentive of key managers
- 44. Causal Ratio Ratio What it measures Fixed assets to net worth Over-investment in fixed assets Collection period Rise in accounts receivable Net sales to inventory Rise in inventory Net sales to net worth Unrestrained growth Net profit to net sales Profitability Miscellaneous assets to net worth Rise in “other” assets
- 45. Fixed Assets to Net Worth • Measures the extent to which capital is tied up in nonliquid, permanent, or depreciable property • Measures the amount of capital remaining for investment in more liquid assets
- 46. Fixed Assets to Net Worth If too much net worth is tied up in fixed assets • Too little working capital • Over-utilize debt • Profitability suffers
- 47. How Fixed Assets Affects Profits • Interest expense • Increased depreciation • Increased property taxes & insurance costs • Reduced working capital • Late charges • Inventory stockouts • Reduced bank balances
- 48. Collection Period • Measures of credit and collection efficiency of the firm, the probability of bad debt write- off, and the company’s receivable position over time and as compared to the industry • If this ratio is too high, it can indicate inefficiency or a decision to allow loose credit terms.
- 49. Collection Period Why is this ratio an important Casual Ratio • Sales attainment • Profitability • Borrowing
- 50. Casual Ratio Summary Problems Reduced Liquidity Increased Leverage Reduced Profits Casual Ratios Large Fixed Assets/Net Worth Large Collection Period Low Inventory Turnover Large Net Sales/Net Worth Low or Negative Profit Margin Large Misc. Assets/Net Worth …caused by
- 52. Types of Analysis • Industry analysis with industry averages or comparison to competitors • Time series analysis with comparison of current year to past years
- 53. Conducting an Analysis • Determine what problems exist. • Compare causal ratios to previous years and to industry averages. • Determine which of the causal ratios are at fault. • Take corrective action.
- 54. Guidelines to use in Ratio Analysis • Ignore isolated figures. • Compare likes. • Study any substantial deviation. • Avoid concentration on high percentages or variances.
- 55. Guidelines to use in Ratio Analysis • Remember that a ratio measures both components. • Recognize the seasonal factor. • Watch for trends. • Be alert to compensating advantages. • Lenders are more Balance Sheet focused • Owners/Managers are more Income Statement driven
- 57. Spontaneous Assets Spontaneous Assets Cash Receivables Inventory* Non-Spontaneous Assets Marketable securities** Prepaid expenses Investments Intangibles Quasi-Spontaneous Fixed Assets
- 58. Spontaneous Liabilities Spontaneous Liabilities Accounts payable Accruals Taxes payable Other non-negotiated short-term debt Non-Spontaneous Liabilities Notes payable – Current Notes payable – Noncurrent Long-term debt Bonds Preferred stock Common stock & paid in capital Quasi-Spontaneous Returned earnings
- 59. The Basic Forecasting Model MISCRE-S S SL -FAS S SA EFN EFN = Amount of external funding to maintain its present condition SA = Ought to increase proportionately as sales increase ∆S = Increase in sales that causes the need for external funding ∆FA = Required to meet increased demand SL = Increase proportionately as sales increase S = Existing sales level ∆RE = (S + ∆S)(PM)(1 − PO) or (S + ∆S)(PM) − $Div MISC = Any other changes to the company’s cash flow in the other expressions
- 60. The Basic Forecasting Model EFN SA S S FA SL S S RE MISC Funds needed Internally generated sources of funds
- 61. Making Assumptions • In forecasting we make assumptions about financial relationships in the future • Our model assumes that future sales levels are a very important determinant of the company’s future financial condition • One basic assumption of our model is that financial relationships of many balance sheet items and sales will remain the same • We can change assumptions as necessary and useful in the model • Testing the importance of assumptions or testing changes in assumptions is called sensitivity analysis.
- 62. Methods of EFN External Sources Debt Bank loans Bonds Loans from owners or officers Insurance company Equity From existing stockholders From new stockholders Internal Sources Decreased payout Increased profit margin Working capital Fixed assets Marketable securities
- 64. What have we covered? • Recognize the need to understand financial statements in everyday business • Understand the basic financial statements • Identify appropriate steps to conduct an analysis • Identify the factors that determine how much external financing is needed
- 65. 46 don’t hesitate to contact us contact address: 202 Gov. St. Mobile, AL 36608 contact: brent@brentmcclure.com www.brentmcclure.com @LBMCPA phone: 205 613 9708
Notas do Editor
- What is a BS. It is essentially a snapshot of the business at a specific point in time, like as of December 31, 2018 or as of June 30, 2019. It also represents the businesses Assets, Liabilities and equity. Generally speaking the assets are listed first or on the left followed by the liabilities and then equity or retained earnings. Assets must equal the liabilities + equity and that’s why it is called a Balance Sheet
- The Income Stmt or Profit & Loss or P&L is the best tool for knowing if your business is profitable or if you have sustained losses. A P&L statement measures revenue (also called sales or income) and expenses over a period of time – whether that is a month, quarter or year. With it you know if you have made a profit (and how much) or if you have incurred a loss.
- The Stmt of Cash flows is my favorite stmt. It essentially measures the amount of cash flowing in and out of the business over a period of time. Normally the stmt of CF and the P&L or Income Stmt are covering the same period. Like it will say for the 12 months ended December 31, 2018 or for the 6 months ended June 30, 2019 or whatever. This statement generally begins with net Income from the P&L and ends with the current cash balance from the Balance Sheet.
- So far I have provided you sort of an overview of the basic financial statements but now I want to take a deeper dive into each and also provide some real life examples…..
- First, let’s start with the BS. As I mentioned before it has Assets with are things that you own – like cash, accounts receivable, inventory – those would be considered current assets b/c you can convert them to cash within a year. Property, Plant & equipment or PPE would also be an asset but a long term asset, like notes receivable b/c they aren’t typically converted into cash within 1 year. Then on the liability side we also have current and non-current. These are things we owe, like accounts payable and short term notes payable or a line of credit are all examples of current liab. b/c/ again they are due within 1 year from the BS date. Non-current or long term liab. Could be notes payable and other long term debt or financing arrangements. Next let’s focus on the equity section and it is primarily made up of equity contributed to the business plus the balance of retained earnings.
- Amazon…
- Now let’s turn our attention to the Income stmt or P&L. Simply put we will have revenues or sales, followed by COGS then operating expenses and then any misc. items such as interest expense and finally or hopefully profits.
- Amazon..
- Starting on this page is Operating Income from the previous page followed by…..
- Now we get to the good part of Cash Flows. We will start with net income followed by cash flows in and out of the business from operating activities like changes in accts receivable, then we have investing activities like purchasing or selling PPE, followed by financing activities as you probably guessed is debt, bonds, movement in stock.
- This is Amazon’s stmt of cash flows, which again is a recon of net income to cash. …..
- So now we know what financial stmts are important and how to look at them, let’s take a dive into several ways of analyzing a financial stmt.
- How much is my business worth? …….. This approach approximates a future dividend stream based on the firm's dividend history and an assumed growth rate, and computes the market capitalization rate that equates it with the current market price. In the case of closely-held firms (such as sole proprietorships and partnerships) which don’t usually distribute profits as dividends, the firms dividend paying capacity is estimated from its average free cash flow and compared with the dividends actually paid by a similar size firm. Also called dividend growth model. Essentially taking FCF and dividing it by the R less the G. so for example….. If your FCF is $2M and your Risk adj. ROR is 10% and your growth rate in perpetuity is 2%, then you are dividing $2m by 8% and getting a business value of $25M
- Let’s talk about ratios….. 2 major classes of ratios.. Cause and effect ratios.. Read slide.. A ratio by itself is almost meaningless, but if we have another company or maybe industry averages to compare our business ratios to then it starts to paint a picture….
- Read slide..
- A look at liquidity ratios again and what category they are measuring…. For example… slide
- The current ratio is my favorite. And specifically it is current assets over current liab. And read slide….
- Another look at the current ratio without inventory is the Quick ratio, this is another one of my favs.
- Slide..
- Slide